Dear Valued Clients and Friends,
There is a lot of anxiety in the economy right now even though the unemployment rate is incredibly low, and nearly every metric on the planet is looking good (besides elevated price indexes). We went month after month last year with people telling us (and many of them seemed to really, really enjoy saying so, mostly because they are awful human beings) that no one would ever shop again, fly again, or “demand” again. The consumption side of the economy was dead behind a brutal pandemic, they said. And we would all be wise to stop paying our office leases, buy some comfortable couch clothes, order food delivery, get an exercise bike delivered, and sit around the house binge-watching TV and just waiting for it all to end.
But now the tune has changed, a lot. Not that drama and intensity – that is the exact same. It’s just the culprit is now the opposite. Now things are too hot, too much activity, too much demand, and prices are too high. That we are supposed to take advice now from the people who zealously told us the opposite 12-18 months ago is odd to me.
But I digress. Pricing pressures exist in the economy and when folks are not talking about Congressional legislation or Fed policy, they are rightly focused on that. Today I want to explain why they are focused on the right thing (price inflation), but for the wrong reason, and more importantly, with the wrong solution. And yes, with an eye towards the right conclusion in your portfolio.
Off we go …
The definition of inflation is, at least from where we sit, “too much money chasing too few goods” (thank you, Milton). Though it alters the convenience of the easy phrase, for precision purposes I would add “and services” to the end of that sentence, and I would echo the point of Dr. Lacy Hunt that Milton Friedman uttered those words in the context of extremely stable, level, and not low “velocity.” He presupposed a continual rate of “turnover” of the money in the system.
Those worried about inflation out of the QE1, QE2, QE3, and now QE-infinity phases of monetary policy post-GFC and more recently post-COVID assumed there would now be “too much money” which would create inflation. Fair enough. The problem was that there wasn’t new money – it stayed in the excess reserves of banks not circulating in the economy
Those worried about inflation post-COVID out of the initial increase in M2 money supply also worried there was now a “too much money” problem. Also fair enough.
But again, Irving Fisher’s quantity theory of money states:
MV = PT
where M is money supply; V is velocity; P is the price level;’ and T is aggregate goods) essentially leaves the V (velocity) as the key ingredient in defining how inflationary an increase in M (money supply) will be to P (prices). A lower V (velocity) leaves the P (prices) lower even when the M (money supply) is increasing (or at least diminishes the inflation of P that M otherwise would represent). Put differently, as a matter of basic algebraic expression:
Lower velocity offsets higher money supply in the calculation of the price level, when T (supply) is level.
The lower V is why the higher M has not meant a substantially higher P. It’s as easy as alphabet soup, right?
But let’s talk about the T for a little bit, shall we?
Demand, meet Supply
The “too few goods (and services)” has always been the ignored ingredient in Milton Friedman’s pithy definition. Huge disinflation became a positive attribute in the economy after the high inflation of the 1970’s and very early 1980’s when (1) the money part of the equation was dealt with to some degree by Paul Volcker tightening monetary policy, and (2) the goods and services part of the equation was dealt with by the supply-side revolution – less regulation, and most profoundly, violent reductions in marginal tax rates, spurred on a huge boost of output.
In those situations (and again, this is algebra) since MV = PT – where T is increasing, the P can stay level even when the M is increasing. MV=PT can be written as P=MV/T and it solves for the exact same thing.
Try it at home. As long as T (supply) is increasing, even a growing M (money supply) keeps the P down (price level). Growing supply of goods and services not only offsets the inflationary effects of a growing money supply, but it makes for a necessary growing money supply to avoid deflation in an economy of growing goods and services.
I think I am following you, but WTH?
See what I did there?
Anyways, why I am going down this path of algebra, economic formulas, and alphabet soup? Because the inflation question has to be re-framed in the context of the T in Irving Fisher’s famous equation – the supply of goods and services.
And this is where supply-siders like me start paying a lot of attention.
What drives a supply of goods and services? Some say demand – that once there is demand for a product, there will be a supply for it to meet that demand. Others follow Say’s Law (Jean Baptiste Say) who famously said, “Supply creates its own demand.” My view is, of course, that a supply of goods and services when attached to human action – human ingenuity – human innovation – human creativity – etc. – always and forever creates the demand, it does not respond to it.
This is the essence of supply-side economics. But it is also the essence of an economic worldview rooted in human action.
No one was demanding a smart phone fifteen years ago that would become your web browser, game player, music player, video watcher, email processor, camera, alarm clock, and God knows what else. Innovation (human action) was attached to the supply (goods and services) of the new creation, and the demand was created from the new invention. The rest is history.
“Supply” (production) is the greatest anti-inflation, pro-growth concoction in all of civilization, and it is the engine of economic prosperity.
And right now, some worry that we do not have enough workers, materials, inventory, and capacity to drive the supply-side of the economy – to meet the post-COVID demands of the current economy. And that when that happens in concert with a rising money supply (M), the result is a higher P (prices).
God save the supply side?
I will leave out the Velocity side of the identity equation for a moment, though ultimately Velocity’s multiplier effect to money supply (or diminishing multiplier effect) can never be ignored. It is the great source of societal disinflation for thirty years – and certainly post-financial crisis.
But what about the supply side? Back to Milton Friedman’s pithy summary, do we face a period of rising prices, not so much because of “too much money” but because of “too few goods”?
*Bridgewater, Research & Insights, Oct. 19, 2021
The chart here sums it up as well as anything I could ever show you. Supply is above trendline, and it is above pre-COVID levels, the level of Demand pick-up has far outpaced the level of Supply pick-up. Granted, this covers consumer goods, for Services reflect a similar delta between demand and supply, albeit with both still < pre-COVID levels.
*Bridgewater, Research & Insights, Oct. 19, 2021
The argument goes that as that Services demand picks up, the tight labor market gets even tighter, and that imbalance pushes wages higher, and we all know that higher wages are inflationary [blah blah blah].
First of all, I don’t know that higher wages are inherently inflationary, but I don’t want to be distracted right now. The question before us is, in fact, a very fair one.
Will supply catch up to demand, offsetting inflationary pressures via a boom in output and productivity? This is the trillion-dollar question.
Sum it up
MV = PT
The M argues for inflation (higher money supply)
The V argues for disinflation (lower velocity)
The T argues for (to be determined) – ultimately P (prices) will look to T (supply) to determine where it will go.
Same as it ever was
The big variable I constantly highlighted pre-COVID around the next inning (or lack thereof) was CAPEX – that is, the business investment necessary to drive further production (supply) – a decade after the financial crisis and its immediate recovery. And now here we are again, with a lot riding on the supply-side of the economy – from pricing pressures to basic economic growth. And whether you are talking about basic commodity production (mining of raw materials) or the investment into the deployment of projects the deficit between demand and supply will only be met by business investment.
It will not be met by government spending, whether or not one likes the various things government proposes to spend money on. It will not be met by monetary policy, where pushing on a string has become an art form.
Some argue there simply isn’t enough productive capacity on the globe to meet the present levels of demand. They make a circular argument that increased CAPEX is needed to meet supply needs in the long term, but the initial bout of capital expenditures becomes another “source of demand” that contributes to an ongoing problem in the short term.
They point to current levels of supplier delivery times which are undoubtedly a disaster right now, in line with the usual cast of characters (inadequate truck drivers, port capacity, port efficiency, and so forth and so on).
They point to labor shortages and the disastrous aftermath of COVID that has left too many people unwilling to work. There are more job openings than job seekers – a reflection of inadequate skills and an underwhelming appetite for employment, a sad combination for a lot of reasons.
And many inexplicably think the best thing we can do is curtail demand. And yes, demand coming down certainly solves for some of the delta between demand and supply.
Sound economics strike again
But no, you can’t ask human beings to want things less. It doesn’t work that way and it never has. You can hike rates and help poke at demand that way, primarily by restricting credit. But it doesn’t matter – because they are not going to do that – and it uses a different remedy as a solution than the area causing the problem (like solving for a toothache by dropping a two-ton block of metal on your foot). The supply side of the economy will dictate where this goes.
And as for those predicting it will come up short, well maybe they are right. I certainly think if a big hike was coming in marginal tax rates on business income, investment income, and personal income it would be devastating to the supply side of the economy. But a moderate Senator in Arizona seems to have taken that off the menu entirely. Significant logistical challenges linger, and there is no sign of any pending aid on the supply-side – boosted incentives for production.
But even if those who forecast supply shortages are right, it is only a question of how long they stay right, because economically they cannot stay right. Market imbalances get cured either slowly or quickly or just right, but that which cannot be, will not be (for long). Herb Stein said something similar once.
I tend to be skeptical of those predicting things that they must know they have no prayer of really knowing how it will shake out in three weeks, let alone six months. There is a need for the economy to be more productive, to close the gap between demand and supply, and with that, to see prices calibrate around money supply in response to the product of their multiplication with goods and services in the economy.
I am investing in supply. Production. Growth. It’s the right solution for our portfolios and the right solution for the economic woes of the day.
Chart of the Week
Quote of the Week
“Half the harm that is done in this world is due to people who want to feel important. They don’t mean to do harm; but the harm does not interest them. Or they do not see it, or they justify it because they are absorbed in the endless struggle to think well of themselves.”
~ T.S. Eliot
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I wish you all a wonderful weekend, filled with good reading, good friends, good family, and good football. And if you get a few moments to produce, it will be good for the economy, and good for your soul.
David L. Bahnsen
Chief Investment Officer, Managing Partner
The Bahnsen Group
This week’s Dividend Cafe features research from S&P, Baird, Barclays, Goldman Sachs, and the IRN research platform of FactSet